market efficiency specific meaning of the term “market efficiency” in financial economics:...
Post on 21-Dec-2015
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Market efficiency
Specific meaning of the term “market efficiency” in financial economics: “security prices fully reflect all available information”
So… this is “Informational Efficiency”
Realistically: an efficient market is one in which information is quickly incorporated into the price.
Tests of market efficiency refer (since Fama, 1970) to three progressively more demanding concepts:
• Weak form • Semi-strong form• Strong form
Market efficiency tests
The difference between the three lies in what information is taken into account:
• Weak form is all info from past prices incorporated?
• Semi-strong is all publicly available info incorporated?
• Strong form is all info, public or private, incorporated?
Market efficiency
• Weak form no additional info from past prices
tests of return predictability
• Semi-strong all publicly available info incorporated
event studies
• Strong form all info, public or private, incorporated
event studies
NB: if strong form is true, then the value of security analysis becomes suspect—though someone must be doing it
Return on equity of takeover targets
around date of takeover attempt
Keown-Pinkerton, 1981, cited in BKM
Market efficiency
Two aspects, both of which are relevant:
• Stock picking
• Timing (especially for the market as a whole)
Tests of return predictability
1. Time patterns
• Monday – 33% (1962-78)• January 5% (small firms)
3% (large firms)
Why? Tax losses? (but worked before 1917)
Tests of return predictability
2. Prediction from past returns
(a) Correlation / regression
(best to use residual from CAPM or APT model to eliminate role of time-varying risk-premia)
Quite a few show significant, albeit small, correlations – especially small shares)
ttt brar 1
Tests of return predictability
2. Prediction from past returns
(b) Runs tests
Ignore size of changes and just look at positive versus negative (avoids overemphasis on unusual extreme events)
Tests of return predictability
2. Prediction from past returns
(c) Filter rules
Such as:
“buy when the stock has increased by (say) 0.5% from its previous low;
sell when stock has fallen by (say) 0.5% from its previous high.”
(Based on the idea that small fluctuations don’t mean news – big fluctuations do)
Tests of return predictability
2. Prediction from past returns
(d) Momentum
For the next month, hold only the stocks that have appreciated over the past year
(or could do this for shorter-term fluctuations)
Used to generate good returns, though high transactions costs. Has faded
Similar: “relative strength”: stocks that are high relative to recent average
Tests of return predictability
2. Prediction from past returns
Most of these tests show small inefficiencies, (especially at very high frequencies – seconds)
Most could not be exploited profitably by investors because of transactions costs
(Transactions costs include the bid-ask spread employed by specialists to defend themselves against better-informed investors)
Tests of return predictability
3. Returns and firm characteristics
The Size Effect (small cap have high returns)
Market-to-book (value firms have high returns)
Earnings-to-price (high earnings firms have high returns)
(These could all be “factor-mimicking” characteristics – capturing additional dimensions of risk )
Tests of return predictability
3. Returns and firm characteristics
The Size Effect
20% extra return on very small vs. large, 1936-77
(risk-adjusted by CAPM)
Only affects lowest quintile of firms
Most of it happens in January!
Size effect
Ibbotson, cited in BKM
Cochrane, EP 99
Small firm portfolios
Tests of return predictability
3. Returns and firm characteristics
Why the size effect?
Maybe beta poorly measured
Small stocks rarely traded – leads to bias in beta estimate
Shrinking firm may have out-of-date beta
Is CAPM a good enough risk adjuster?
Using other risk factors (though not size) in an APT
reduced the size factor a lot (11% to <2%)
Key factor here: risk-premium on corporate bonds
relative to govt bonds
Tests of return predictability
3. Returns and firm characteristics
Why the size effect?
Transactions costs especially high
Compensation for liquidity
Impossible to profit from effect?
Tests of return predictability
3. Returns and firm characteristics
The Book-to-market effectGap of 8% per annum between highest and lowest deciles of firms
ranked by the ratio of their book value to market value(high B/M predicts high return)
Maybe value firms are close to bankruptcy but recovered – so these firms are not a hedge for recession, hence high yield
“Value” (high B/M) and “Growth” (low B/M) stocks (These terms not quite synonymous with B/M)
The Earning-to-price effectBut this seems to have no independent effect after size and
market-to-book taken account of.
The neglected firm effect
Book to market effect
French, cited in BKM
Tests of return predictability
3. Returns and firm characteristicsQuestions to ask about any of these anomalies:
• Is it real? (Data-mining)• Are we just missing another factor (especially one
correlated with investors’ consumption/welfare)(i.e. firm characteristics correlated with a risk-factor that the market prices but we have omitted)
• Mis-estimate of beta (or other factor loadings)?• Transactions costs?• Risk premia changing over time?
(CAPM/APT use stable λ’s)Truly inefficient?